Strategic Decision Making in Oligopoly Markets

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1 Strategic Decision Making in Oligopoly MarketsChapter 13Strategic Decision Making in Oligopoly Markets

2 Oligopoly Markets Interdependence of firms’ profitsDistinguishing feature of oligopolyArises when number of firms in market is small enough that every firms’ price & output decisions affect demand & marginal revenue conditions of every other firm in market

3 Strategic Decisions Strategic behavior Game theoryActions taken by firms to plan for & react to competition from rival firmsGame theoryUseful guidelines on behavior for strategic situations involving interdependence

4 Simultaneous DecisionsOccur when managers must make individual decisions without knowing their rivals’ decisions

5 Dominant StrategiesAlways provide best outcome no matter what decisions rivals makeWhen one exists, the rational decision maker always follows its dominant strategyPredict rivals will follow their dominant strategies, if they existDominant strategy equilibriumExists when when all decision makers have dominant strategies

6 Prisoners’ Dilemma All rivals have dominant strategiesIn dominant strategy equilibrium, all are worse off than if they had cooperated in making their decisions

8 Dominated StrategiesNever the best strategy, so never would be chosen & should be eliminatedSuccessive elimination of dominated strategies should continue until none remainSearch for dominant strategies first, then dominated strategiesWhen neither form of strategic dominance exists, employ a different concept for making simultaneous decisions

11 Making Mutually Best DecisionsFor all firms in an oligopoly to be predicting correctly each others’ decisions:All firms must be choosing individually best actions given the predicted actions of their rivals, which they can then believe are correctly predictedStrategically astute managers look for mutually best decisions

12 Nash EquilibriumSet of actions or decisions for which all managers are choosing their best actions given the actions they expect their rivals to chooseStrategic stabilityNo single firm can unilaterally make a different decision & do better

14 Nash EquilibriumWhen a unique Nash equilibrium set of decisions existsRivals can be expected to make the decisions leading to the Nash equilibriumWith multiple Nash equilibria, no way to predict the likely outcomeAll dominant strategy equilibria are also Nash equilibriaNash equilibria can occur without dominant or dominated strategies

15 Best-Response CurvesAnalyze & explain simultaneous decisions when choices are continuous (not discrete)Indicate the best decision based on the decision the firm expects its rival will makeUsually the profit-maximizing decisionNash equilibrium occurs where firms’ best-response curves intersect

18 Sequential DecisionsOne firm makes its decision first, then a rival firm, knowing the action of the first firm, makes its decisionThe best decision a manager makes today depends on how rivals respond tomorrow

19 Game TreeShows firms decisions as nodes with branches extending from the nodesOne branch for each action that can be taken at the nodeSequence of decisions proceeds from left to right until final payoffs are reachedRoll-back method (or backward induction)Method of finding Nash solution by looking ahead to future decisions to reason back to the current best decision

21 First-Mover & Second-Mover AdvantagesFirst-mover advantageIf letting rivals know what you are doing by going first in a sequential decision increases your payoffSecond-mover advantageIf reacting to a decision already made by a rival increases your payoff

22 First-Mover & Second-Mover AdvantagesDetermine whether the order of decision making can be confer an advantageApply roll-back method to game trees for each possible sequence of decisions

26 CommitmentsManagers announce or demonstrate to rivals that they will bind themselves to take a particular action or make a specific decisionNo matter what action or decision is taken by rivals

27 Threats & Promises Conditional statements Threats PromisesExplicit or tacit“If you take action A, I will take action B, which is undesirable or costly to you.”Promises“If you take action A, I will take action B, which is desirable or rewarding to you.”

28 Cooperation in Repeated Strategic DecisionsCooperation occurs when oligopoly firms make individual decisions that make every firm better off than they would be in a (noncooperative) Nash equilibrium

29 Cheating Making noncooperative decisions One-time prisoners’ dilemmasDoes not imply that firms have made any agreement to cooperateOne-time prisoners’ dilemmasCooperation is not strategically stableNo future consequences from cheating, so both firms expect the other to cheatCheating is best response for each

31 Punishment for CheatingWith repeated decisions, cheaters can be punishedWhen credible threats of punishment in later rounds of decision making existStrategically astute managers can sometimes achieve cooperation in prisoners’ dilemmas

32 Deciding to Cooperate Cooperate CheatWhen present value of costs of cheating exceeds present value of benefits of cheatingAchieved in an oligopoly market when all firms decide not to cheatCheatWhen present value of benefits of cheating exceeds present value of costs of cheating

37 Price MatchingFirm publicly announces that it will match any lower prices by rivalsUsually in advertisementsDiscourages noncooperative price-cuttingEliminates benefit to other firms from cutting prices

38 Sale-Price GuaranteesFirm promises customers who buy an item today that they are entitled to receive any sale price the firm might offer in some stipulated future periodPrimary purpose is to make it costly for firms to cut prices

40 Price LeadershipPrice leader sets its price at a level it believes will maximize total industry profitRest of firms cooperate by setting same priceDoes not require explicit agreementGenerally lawful means of facilitating cooperative pricing

41 Cartels Most extreme form of cooperative oligopolyExplicit collusive agreement to drive up prices by restricting total market outputIllegal in U.S., Canada, Mexico, Germany, & European Union

42 CartelsPricing schemes usually strategically unstable & difficult to maintainStrong incentive to cheat by lowering priceWhen undetected, price cuts occur along very elastic single-firm demand curveLure of much greater revenues for any one firm that cuts priceCartel members secretly cut prices causing price to fall sharply along a much steeper demand curve

49 Capacity ExpansionEstablished firm(s) can make the threat of a price cut credible by irreversibly increasing plant capacityWhen increasing capacity results in lower marginal costs of production, the established firm’s best response to entry of a new firm may be to increase its own level of productionRequires established firm to cut its price to sell extra output